Reducing Transaction and Information Costs

1. Reducing Transaction and Information Costs Hubbard Chapters 11 & 12

2. Puzzles of Financial Structure • Stocks are not the most important source of finance for business • Issuing marketable securities is not the primary funding source for business • Indirect finance (financial intermediation) is far more important than direct finance • Banks are the most important source of external finance

3. Puzzles of Financial Structure(cont.) • The financial system is among the most heavily regulated sectors of the economy • Only large, well established firms have access to securities markets • Collateral is a prevalent feature of debt contracts • Debt contracts are typically extremely complicated documents

4. An understanding of the eight puzzles of financial structure requires an understanding of the role of asymmetric information.

5. Asymmetric Information • Definition Occurs when one party has • insufficient information • inaccurate information necessary to make an optimal decision

6. Adverse Selection • Definition: • problem created by asymmetric information before a transaction occurs • leads to the “lemons problem”

7. Lemons Problem(as applied to financial markets) • those parties who are the least desirable from the opposing party’s point of view are the ones that are most likely to want to engage in the financial transaction • because the investor has insufficient knowledge of the quality of potential borrowers, they will be willing to pay a price for the financial claim that reflects the average quality of borrowers • consequently, high quality issuers will choose not to issue (price they expect to receive will be to low) • purchasers will learn this and choose not to buy (only average to low quality issues available)

8. Adverse Selection(continued) • Importance of Adverse Selection • explains why the best SSUs may choose not to issue DFCs • explains why most SSUs choose not to purchase DFCs • explains why stocks and bonds are not the primary source of external finance • keeps direct finance from being a more effective channel of funds from SSUs to DSUs • explains why direct finance is used primarily by large, well know corporations & gov’t.

9. Solutions to Adverse Selection • Information Production • free-rider problem • Government Regulation • Collateral and Net Worth • Financial Intermediation

10. Solutions to Adverse Selection(continued) • Private Information Production- • private firms produce information and sell it • information is designed to help investors distinguish between high and low quality investment • Leads to “free-rider problem” • people who do not pay for the information can observe those who do and act accordingly • result is that value of private information production is reduced or eliminated • thus private information production cannot eliminate the lemons problem unless the free-rider problem can also be eliminated

11. Solutions to Adverse Selection(continued) • Government Regulation • government could regulate the securities markets to encourage firms to reveal honest information that investors can use to distinguish between high and low quality firms • Securities and Exchange Commission performs this function in the US • requires firms to • adhere to standard accounting procedures • disclose information • government could produce information themselves and provide it free or at low cost • however this would mean using tax money to publish negative information about US companies- politically unfeasible?

12. Solutions to Adverse Selection(continued) • Collateral and networth • adverse selection interfers with the functioning of financial markets only if investors/lenders suffer losses • collateral and net worth reduce investor/lender losses associated with default

13. Moral Hazard Defined: An asymmetric information problem occuring after the financial transaction takes place. The seller of a financial claim may have an incentive to hide information and engage in activities contrary to the interests of the investor/lender.

14. Solutions to Moral Hazard • Agency costs (Cost of monitoring for compliance) • Incentive Compatible Contracts • executive and employee compensation • restrictive covenants • collateral and net worth • Government Regulation • Financial Intermediation

15. Solutions to Moral Hazard • principal-agent problem • principals (owners) and agents (managers and employees hired by the owners) have and pursue different objectives • moral hazard would not occur if owners had complete information about what managers and employees were doing and could prevent adverse decisions • agency costs could be incurred to monitor behavior • these costs and the ability of some shareholders to free ride on the monitoring of others, make equity contracts less desirable • using debt instead of equity increases expenses, thereby reducing net income (i.e. free cash flow) available for managers to use at their discretion

16. Solutions to moral hazard • government regulations require firms to adhere to standard accounting principles, laws against fraud • non compliance and fraud are hard to identify and prove • high net worth and the use of collateral make debt contracts more incentive compatible • performance based compensation makes equity contracts more incentive compatible • monitoring and restrictive covenants reduce the opportunity to expropriate wealth - moral hazard

17. Moral Hazardequities vs. debt • more severe for equities • the incentive-compatibility, principal-agent or agency problem • equity - seek profit maximization • debt - maintain ability to service debt

18. Moral Hazard(continued) • Importance of Moral Hazard • helps explain why stocks and bonds are not the primary sources of external finance • keeps direct finance from being a more effective channel of funds from SSUs to DSUs

19. Factors that Increase the Adverse Selection and Moral Hazard Problems • Financial Economists have identified 5 economic factors that increase these two asymmetric information problems • increases in interest rates increase the adverse selection problem because the better borrowers will refuse to borrow at the higher rates • Falling prices cause a loss of collateral value and of borrower net worth so the adverse selection and moral hazard problems increase

20. Factors that Increase the Adverse Selection and Moral Hazard Problems • A decline in the stock market also causes a loss of firm value and will increase both the moral hazard and adverse selection problems • An increase in risk will make it harder for intermediaries to screen the bad from the good borrowers and will lead to fewer loans being made • Bank panics may cause banks to go out of buiness and reduce the number of loans available

21. Conclusion: Why Direct Finance is a Small Part of Total Financing • Can’t solve mismatch • Adverse Selection • costly information • free-rider problem • Moral Hazard • principal-agent problem • costly monitoring • free-rider problem

22. Indirect Finance as a Solution • Indirect Finance • financial intermediaries • depository (banks, S&Ls, credit unions) • contractural (insurance cos., pension funds) • others (investment cos., finance cos.)

23. Indirect Finance (continued) • create & sell indirect financial claims • liabilities of these intermediaries • tailored to needs of SSUs • purchase DFCs • make loans to DSUs • purchase stocks & bonds • both an IFC and a DFC is created!

24. Services Produced by Financial Intermediaries • Asset Transformation • risk transformation • liquidity transformation • maturity transformation • denomination transformation

25. Services Produced by Intermediaries (continued) • Reduced Transactions Costs • Economies of Scale • Reduce Adverse Selection and Moral Hazard Problems • Search Costs • Information Production • prevent free-rider problem • Monitoring

26. Asset Transformation Services provided by intermediaries

27. Solving the Mismatch • Denomination mismatch • 200 depositors with $500 deposits can fund a $100,000 mortgage • Maturity mismatch • a five year auto loan can be funded by rolling over one-year time deposits each year

28. Solving the Mismatch 200 Depositors with $500 Deposits Pool of $100,000 Fund a single $100,000 Mortgage

29. Solving the Mismatch(continued) • Liquidity mismatch • if the bank estimates a that two of its 200 depositors will withdraw funds it can: • fund the loan with 202 depositors, each with $500 deposits and hold $1000 in cash or • fund the loan with 202 depositors, each with $500 deposits and invest the extra $1,000 in T-Bills • anticipate that it can replace those two depositors with two new ones

30. Solving the Mismatch replace lost deposits with new deposits $100,000 Pool of Funds mort. loan

31. Solving the Mismatch pool of funds deposits loan cash or liquid assets

32. Solving the Mismatch • Risk mismatch • use their expertise • use their information advantage • use their ability to diversify

33. Providing Intermediation Services at a Profit Assumptions: • Intermediary pays 5% to purchasers (SSUs) of its indirect financial claims (low risk, high liquidity) • Intermediary earns 10% on its purchases of direct financial claims from DSUs (higher risk, lower liquidity) • Intermediary incurs $3.2 m. in administrative costs

34. Sources of Intermediary Profits (continued) • Intermediary has $100 m. of total assets • Intermediary has $100 m. of total liabilities • Intermediary has a default rate of 2% of assets Revenues .10x(100 - 2) = $9.8 m. less defaults .02x100 = - 2.0 m. less adm. csts = - 3.2 m. less int. exp. .05x(100) = - 5.0 m. net income = - 0.4 m.

35. Ability to Reduce Risk • Intermediary is able to reduce defaults to 1% through better credit risk evaluations and diversification Revenues .10x(100 - 1) = $9.9 m. less defaults .01x100 = - 1.0 m. less adm. csts = - 3.2 m. less int. exp. .05x(100) = - 5.0 m. net income = + 0.7 m. ROA=.7/100= 0.70%

36. Economies of Scale • Economies of Scale occur when costs rise less quickly than output. • Suppose that administrative costs risk by 9% when assets and liabilities increase by 10% • Continue to assume a default rate of 1% on assets

37. Economies of Scale (continued) Revenues .10x(110 - 1.1) = $10.89 m. less defaults .01x110 = - 1.1 m. less adm. csts 1.09x3.2 = - 3.48 m. less int. exp. .05x(110) = - 5.5 m. net income = + 0.81 m. ROA=.81/100= 0.81%

38. Solving Asymmetric Information Problems Adverse Selection and Moral Hazard

39. Intermediaries and Adverse Selection • specialize in private loans (nontraded) • reduces the free-rider problem • collateral and net worth requirements reduces potential losses • experts in information production • lend only to “quality borrowers” • smaller, less well known borrowers • no direct access to capital markets • minimizes free-rider problem

40. Intermediaries and Moral Hazard • focus on nontraded financial claims • more incentive to monitor • larger financial stake • may take ownership stake • reduction of free-rider problem • imposition of covenants & collateral • incentive-compatible

41. Regulation of Financial Markets • Three Main Reasons for Regulation • Increase Information to Investors • decrease adverse selection and moral hazard problems • SEC forces corporations to disclose information • Ensuring the Soundness of Financial Intermediaries • prevents financial panics • chartering reporting requirements, restrictions on assets and activities, deposit insurance, and anti-competitive measures

42. Regulation of Financial Markets(continued) • Improving Monetary Control • reserve requirements • deposit insurance to prevent bank runs • Consumer Protection • prevent or reduce exploitation of market power by more savy, more financially powerful businesses